CFA Level 1 | [MOCK EXAMS] + [SOLUTIONS] 2021

2019 Level I Mock Exam AM 57 C is incorrect because it is: $8/$108 = 0.0741. Introduction to Fixed-I­ncome Valuation LOS f Section 3 104 Which of the following statements is most likely correct regarding the spot and forward curves. The spot curve: A can be calculated from the forward curve, and the forward curve can be calculated from the spot curve. B can be calculated from the forward curve, but the forward curve cannot be calculated from the spot curve. C cannot be calculated from the forward curve, but the forward curve can be calculated from the spot curve. A is correct. The forward and spot curves are interconnected to each other. The spot curve can be calculated from the forward curve, and the forward curve can be calculated from the spot curve. Either curve can be used to value fixed-­rate bonds. B is incorrect because the spot curve can be calculated from the forward curve, and the forward curve can be calculated from the spot curve. C is incorrect because the spot curve can be calculated from the forward curve, and the forward curve can be calculated from the spot curve. Introduction to Fixed-­Income Valuation LOS g Section 4 105 An investor purchases an option-f­ree bond paying an annual coupon rate of 10% and maturing in 10 years at its par value of $100. The investor sells the bond after seven years, receiving a total of seven coupons over this period. Assume that the coupons are reinvested at an annual interest rate of 8% over the investor’s holding period. The future value of the reinvested coupon pay- ments at the end of the investor’s holding period is closest to: A 70.00. B 75.90. C 89.23. C is correct. The future value of the reinvested coupon payments is computed as follows: 10(1.08)6 + 10(1.08)5 + 10(1.08)4 + 10(1.08)3 + 10(1.08)2 + 10(1.08)1 + 10 = 89.23 A is incorrect because it computes the future value of the coupon payment by just adding them up.

58 2019 Level I Mock Exam AM B is incorrect because it uses a reinvestment rate of 10% and a coupon payment of 8.00, as follows: 8(1.10)6 + 8(1.10)5 + 8(1.10)4 + 8(1.10)3 + 8(1.10)2 + 8(1.10)1 + 8 = 75.90 Understanding Fixed‑Income Risk and Return LOS a Section 2 106 Which of the following statements is least accurate regarding the factors that affect the interest rate risk characteristics of an option-f­ree bond? A The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates. B The higher the yield, the greater the bond’s price sensitivity to changes in interest rates. C The longer the bond’s maturity, the greater the bond’s price sensitivity to changes in interest rates. B is correct. Option-­free bonds have positive convexity. The higher the yield to maturity, the lower the duration (and thus the lower the interest rate risk). A is incorrect because bonds with longer maturities have higher interest rate risks. C is incorrect because bonds with lower coupon rates have higher interest rate risks. Understanding Fixed-­Income Risk and Return LOS e Section 3.3 107 Which of the following events will most likely increase the short-t­erm bond yield volatility? A Slow economic growth expectation B Central bank engaging in expansionary monetary policy C High inflation expectation B is correct. A central bank engaging in expansionary monetary policy might cause the yield curve to steepen by reducing short-­term interest rates and thus cause greater volatility in short-t­erm bond yields to maturity than in longer-­term bonds. A is incorrect because slow economic growth expectation will have more impact on the longer-­term bond yield volatility. C is incorrect because high inflation expectation will have more impact on the longer-­ term bond yield volatility. Understanding Fixed-­Income Risk and Return LOS j Section 4.1 108 Valuation of a swap during its life will least likely involve the: A application of the principle of no arbitrage.

2019 Level I Mock Exam AM 59 B use of replication. C investor’s risk aversion. C is correct. Risk neutrality, not risk aversion, is a key element of derivatives pricing, including swaps. A is incorrect. The statement is true because the principle of no arbitrage is applied in pricing swaps. B is incorrect. The statement is true because replication is used in pricing swaps. Basics of Derivative Pricing and Valuation LOS a Section 1 109 If a forward contract requires no cash outlay at initiation, it is most likely true that at initiation: A value exceeds price. B price exceeds value. C price is equal to value. B is correct. At initiation, value is equal to zero. Price is a positive number that states the amount that must be paid when the purchase takes place. A is incorrect. Value is zero; price is a positive number. C is incorrect. Value is zero; price is a positive number. Basics of Derivative Pricing and Valuation LOS b Section 2.4 110 A forward rate agreement most likely differs from most other forward contracts because: A positions cannot be closed out prior to maturity. B it involves an option component. C its underlying is not an asset. C is correct. Forward rate agreements, unlike most other forward contracts, do not have an asset as an underlying. Instead, the underlying is an interest rate. A is incorrect. Forward rate agreements can also be closed out prior to maturity. B is incorrect. Forward rate agreements do not involve an option component. Basics of Derivative Pricing and Valuation LOS e Section 3.1.4 111 The pricing of forwards and futures will most likely differ if:

60 2019 Level I Mock Exam AM A interest rates exhibit zero volatility. B futures prices and interest rates are negatively correlated. C futures prices and interest rates are uncorrelated. B is correct. The pricing of forwards and futures will differ if futures prices and interest rates are negatively correlated. A negative correlation between futures prices and interest rates makes forwards more desirable than futures in the long position. A is incorrect. If interest rates exhibit zero volatility, the pricing of forwards and futures will be identical. C is incorrect. If futures prices and interest rates are uncorrelated, the pricing of for- wards and futures will be identical. Basics of Derivative Pricing and Valuation LOS f Section 3.2 112 The price of an interest rate swap that involves the exchange of a fixed payment for a floating payment is most likely: A equal to its value at expiration. B set at initiation and constant over time. C affected by changes in the floating payment. B is correct. Swaps have both a price and a value. Price in the context of a swap is a ref- erence to the fixed-­rate payment on the swap, which is constant over time. The value of a swap is zero at initiation but can change over the life of the swap as market interest rates change. A is incorrect. Price and value are not normally equal at expiration. C is incorrect. The price in the context of a swap is a reference to the fixed-r­ate payment on the swap, which is constant over time and does not change in reaction to interest rate changes. Basics of Derivative Pricing and Valuation LOS h Section 3.3 113 Using put–call parity, a long call can best be replicated by going: A long the put, short the asset, and long the bond. B short the put, long the asset, and short the bond. C long the put, long the asset, and short the bond. C is correct. According to put–call parity, a long call is equal to long put, long asset, short bond. A is incorrect. The short asset position must be a long position, and the long bond position must be a short position. According to put–call parity, a long call is equal to long put, long asset, short bond.

2019 Level I Mock Exam AM 61 B is incorrect. The short put position must be a long position. According to put–call parity, a long call is equal to long put, long asset, short bond. Basics of Derivative Pricing and Valuation LOS l Section 4.1.9 114 For a call option, if the underlying asset’s value is less than the option’s exercise price, the option is said to be: A at the money. B out of the money. C in the money. B is correct. If the underlying asset’s value is less than the option’s exercise price, the call option is not worth exercising and is said to be out of the money. A is incorrect. For an at-t­he-m­ oney call option, the value of the underlying asset is equal to the option’s exercise price, and the option buyer would be indifferent between exercising or not exercising the option. C is incorrect. For an in-­the-­money call option, the value of the underlying asset is greater than the option’s exercise price, and the option is worth exercising. Derivative Markets and Instruments LOS c Section 4.2.1 115 A least likely reason for investors to include commodity derivatives in their investment portfolios is: A commodity-r­ elated stocks’ positive correlation with the overall equity market. B it eliminates the need to understand the physical supply chain and general supply–demand dynamics of a commodity. C the tendency for commodity prices to be positively correlated with inflation. B is correct. Because the prices of commodity derivatives are, to a significant extent, a function of the underlying commodity prices, it is important to understand the physical supply chain and general supply–demand dynamics of a commodity. A is incorrect because commodity-­related stocks tend to exhibit a high degree of correlation with the overall equity market. High correlation means low diversification benefits, which reduces the appeal of including this type of investment in a portfolio so investors may be drawn to commodity derivatives that have a lower correlation with the overall equity market. C is incorrect because commodity prices tend to be positively correlated with inflation. Introduction to Alternative Investments LOS a, c Section 6

62 2019 Level I Mock Exam AM 116 Hedge funds are least likely to have restrictions concerning: A the withdrawal of invested funds. B the use of derivatives. C the number of investors in the fund. B is correct. The use of derivatives is a typical feature of contemporary hedge funds. A is incorrect. Hedge funds tend to impose restrictions on the withdrawal of funds. C is incorrect. Investing in hedge funds is open only to a limited number of investors. Introduction to Alternative Investments LOS b Section 3 117 Which of the following is most likely a private equity strategy? A Merger arbitrage B Venture capital C Quantitative directional B is correct. Venture capital is a private equity strategy in which private equity companies invest and get actively involved in the management of portfolio companies. A is incorrect. This is a hedge fund strategy. C is incorrect. This is a hedge fund strategy. Introduction to Alternative Investments LOS d Section 4.2.2 118 Which of the following characteristics of a target company is likely the least attractive for a leveraged buyout? A Substantial amount of physical assets B Strong and sustainable cash flow C High leverage C is correct. Low leverage is an attractive feature of a target company in a leveraged buyout. This characteristic makes it easier for an acquirer to use debt to finance a large portion of the purchase price. A is incorrect. A substantial amount of physical assets is a desirable feature of a target company in a leveraged buyout. B is incorrect. A strong and sustainable cash flow is a desirable feature of a target company in a leveraged buyout. Introduction to Alternative Investments LOS d Section 4.2.1.2

2019 Level I Mock Exam AM 63 119 If the price of a commodity futures contract is below the spot price, it is most likely that the: A cost of carry exceeds the convenience yield. B roll yield is negative. C convenience yield exceeds storage costs. C is correct. The convenience yield must exceed the cost of carry to arrive at a futures price below the spot price because the futures price is approximately equal to the spot price [(1 + r) + Storage cost – Convenience yield] and the cost of carry is defined as interest cost plus storage cost. Given that interest cost is always positive, the convenience yield must also exceed storage costs to arrive at a futures price below the spot price. A is incorrect. If the cost of carry exceeds the convenience yield, the futures price is above the spot price. B is incorrect. Roll yield is defined as the difference between the spot price and the price of the futures contract. If the price of a commodity futures contract is below the spot price, roll yield is positive. Introduction to Alternative Investments LOS e Section 6.4.1 120 Investors will most likely have difficulty managing diversification across hedge funds if the funds: A make decisions via investment committees. B fail to appoint chief risk officers. C seek to keep their strategies private. C is correct. The lack of transparency in positions and strategies makes it difficult for investors to effectively manage diversification across funds. A is incorrect. Decision making by an investment committee does not limit the infor- mation needed for an investor when considering diversification benefits. B is incorrect. Failure to appoint a chief risk officer does not limit the information needed for an investor when considering diversification benefits. Introduction to Alternative Investments LOS g Section 8.1.3

2019 Level I Mock Exam PM The afternoon session of the 2019 Level I Chartered Financial Analyst® Mock Examination has 120 questions. To best simulate the exam day experience, candidates are advised to allocate an average of one and a half minutes per question for a total of 180 minutes (3 hours) for this session of the exam. Questions Topic Minutes 1–19 Ethical and Professional Standards 28.5 20–31 Quant 18 32–43 Econ 18 44–61 Financial Reporting and Analysis 27 62–73 Corporate Finance 18 74–80 Portfolio Management 10.5 81–93 Equity 19.5 94–106 Fixed Income 19.5 107–113 Derivatives 10.5 114–120 Alternative Investments 10.5 Total: 180 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates. Candidates may view and print the exam for personal exam prepara- tion only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-r­ egistered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose © 2018 CFA Institute. All rights reserved.

2 2019 Level I Mock Exam PM 2019 LEVEL I MOCK EXAM PM 1 Which of the following least likely forms the basic structure for enforcement of the CFA Institute Professional Conduct Program? A Bylaws B Rules of Procedure C Board of Governors C is correct. Although the Board of Governors maintains oversight and responsibility for the Professional Conduct Program, the CFA Institute Bylaws and Rules of Procedure form the basic structure for enforcement of the Code and Standards. A is incorrect because although the Board of Governors maintains oversight and responsibility for the Professional Conduct Program the CFA Institute Bylaws and Rules of Procedure form the basic structure for enforcement of the Code and Standards. B is incorrect because although the Board of Governors maintains oversight and responsibility for the Professional Conduct Program the CFA Institute Bylaws and Rules of Procedure form the basic structure for enforcement of the Code and Standards. Code of Ethics and Standards of Professional Conduct LOS a 2 Ross Nelson, CFA, manages accounts for high-n­ et-w­ orth clients including his own family’s account. He has no beneficial ownership in his family’s account. Because Nelson is concerned about the appearance of improper behavior in managing his family’s account, when his firm purchases a block of securities, Nelson allocates to his family’s account only those shares that remain after his other client accounts have their orders filled. The fee for managing his family’s account is based on his firm’s normal fee structure. According to the Standards of Practice Handbook, Nelson’s best course of action with regard to manage- ment of his family’s account would be to: A treat the account like other client accounts. B treat the account like other employee accounts of the firm. C remove himself from any direct involvement by transferring responsibility for this account to another investment professional in the firm. A is correct as Nelson has breached his duty to his family by treating them differently from other clients. They are entitled to the same treatment as any other client of the firm. Nelson should treat his family’s account like any other client account [Standard III(B) related to fair dealing and Standard VI(B) related to Priority of Transactions]. B is incorrect as this action is not necessary. C is incorrect as this action is not necessary. Guidance for Standards I–VII LOS a Standard III(B)–Fair Dealing, Standard VI(B)–Priority of Transactions

2019 Level I Mock Exam PM 3 3 Several years ago, Leo Peek, CFA, co-f­ounded an investment club. The club is fully invested but has not actively traded its account for at least a year and does not plan to resume active trading of the account. Peek’s employer requires an annual disclosure of employee stock ownership. Peek discloses all of his personal trading accounts, but does not disclose his holdings in the invest- ment club. Peek’s actions are least likely to be a violation of which of the CFA Institute Standards of Professional Conduct? A Misrepresentation B Transaction priority C Conflicts of interest B is correct as there is no indication that the investment club is trading ahead of clients [Standard VI(B)]. A is incorrect as information concerning the investment has been misrepresented due to the lack of disclosure [Standard I(C)]. C is incorrect as members should disclose all beneficial ownership that could rea- sonably cause a conflict of interest. Additionally, because Peek’s employer requires the disclosure, a failure to provide full information would violate his employer’s policies and CFA Institute Standards of Professional Conduct [Standard VI(A)]. Guidance for Standards I–VII LOS a Standard  I(C)–Misrepresentation, Standard  VI(A)–Disclosure of Conflicts, Standard  VI(B)–Priority of Transactions 4 Madeline Smith, CFA, was recently promoted to senior portfolio manager. In her new position, Smith is required to supervise three portfolio managers. Smith asks for a copy of her firm’s written supervisory policies and procedures, but is advised that no such policies are required by regulatory standards in the country where Smith works. According to the Standards of Practice Handbook, Smith’s most appropriate course of action would be to: A require her firm to adopt the CFA Institute Code of Ethics and Standards of Professional Conduct. B require the employees she supervises to adopt the CFA Institute Code of Ethics and Standards of Professional Conduct. C decline to accept supervisory responsibility until her firm adopts procedures to allow her to adequately exercise such responsibility. C is correct because if a member cannot fulfill supervisory responsibilities because of the absence of a compliance system or because of an inadequate compliance system, the member should decline in writing to accept supervisory responsibility until the firm adopts reasonable procedures to allow the member to adequately exercise such responsibility [Standard IV(C)]. A is incorrect because these actions will not provide a complete compliance system with which the portfolio manager can adequately exercise her supervisory responsibilities.

4 2019 Level I Mock Exam PM B is incorrect because these actions will not provide a complete compliance system with which the portfolio manager can adequately exercise her supervisory responsibilities. Guidance for Standards I–VII LOS a Standard IV(C)–Responsibilities of Supervisors 5 Marc Davidson, CFA, works as a trust specialist for Integrity Financial. On his own time, Davidson starts a part time consulting business providing advice to Trustees for a fee. He conducts this business on his own time. Davidson asks his assistant to compile a list of Integrity’s clients and their contact information. The following month, Davidson is offered a similar role at Integrity’s largest competitor, Legacy Trust Services, Inc. After he begins working at Legacy, his new manager arranges for him to meet with a number of prospective clients, many of whom are clients of Integrity. After meeting with Davidson, a num- ber of former Integrity clients decide to transfer their business to Legacy. Did Davidson’s action violate the Code and Standards? A No. B Yes, Davidson’s part time consulting business is a violation of the Standards. C Yes, both Davidson’s part time consulting business and his meetings with Integrity clients are a violation of the Standards. B is correct because members and candidates are required to disclose any compen- sation arrangement to their employers that involves performing tasks or services that their employers can charge for. Disclosure is required even if the activities occur during non-­work hours. C is incorrect because being hired by a competing firm does not constitute a vio- lation of Standard IV(A). In addition, Davidson is not utilizing confidential information from Integrity to solicit former clients. Although Davidson had a list of client contacts prepared while at Integrity, his new employer arranges the meetings. A is incorrect because his consulting business is a violation of Standard IV(A). Guidance for Standards I–VII LOS b Standard IV(A)–Loyalty 6 Lee Chu, a CFA candidate, develops a new quantitative security selection model exclusively through back-t­esting on the Chinese equity market. Chu is asked to review marketing materials including an overview of the conceptual frame- work for his model, providing back-t­ested performance results, and listing the top holdings. Chu directs the marketing group to remove the description of his model due to concerns competitors may attempt to replicate his investment philosophy. He also instructs the marketing group to remove the list of the top holdings because it shows that the top holding represents 30 percent of the back-­tested model. Which of the following actions is least likely to result in a violation of the Code and Standards? Chu’s: A use of back-­tested results in communication with prospective clients. B failure to adequately describe the investment process to prospective clients. C failure to disclose that the top holding represents such a large allocation in the model.

2019 Level I Mock Exam PM 5 A is correct because use of back-­tested results is not prohibited, providing it is appro- priately disclosed. B in incorrect because under Standard V(B) members and candidates must adequately describe to clients and prospective clients the manner in which the member or candidate conducts the investment decision making process. C is incorrect because Chu is intentionally omitting a material fact regarding the con- centration of the model portfolio which would likely have an impact on the prospective client’s perception of the riskiness of this strategy. Guidance for Standards I–VII LOS b Standard V(B)–Communication with Clients and Prospective Clients 7 Bob White is a new CFA charterholder and he is updating his resume and com- pany biography (bio) to reflect this accomplishment. In his bio, he states that he successfully passed all three CFA exams in three consecutive years. On his resume he adds the following line: “CFA, 2013, CFA Society of Pittsburgh”. Are either his bio or his resume in violation of the Standards regarding referencing the CFA designation and program? A No. B Yes, his resume is incorrect. C Yes, both his bio and his resume are in violation of the Standards. B is correct because his resume should read CFA, 2013, CFA Institute. The resume is incorrect because it lists the CFA Society of Pittsburgh instead of the CFA Institute as the organization associated with the CFA designation. A is incorrect because his resume is wrong. C is incorrect because stating that he passed the three exams in three years is simply a statement of fact (assuming it is true) and permissible. Guidance for Standards I–VII LOS b Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program 8 Kim Klausner, CFA, monitors several hundred employees as head of compliance for a large investment advisory firm. Klausner has always ensured that his com- pany’s compliance program met or exceeded those of its competitors. Klausner, who is going on a long vacation, has delegated his supervisory responsibilities to Sue Chang. Klausner informs Chang that her responsibilities include detect- ing and preventing violations of any capital market rules and regulations, and the CFA Institute Code and Standards. Klausner least likely violated the CFA Institute Standards of Professional Conduct by failing to instruct Chang to also consider: A firm policies. B legal restrictions. C industry standards.

6 2019 Level I Mock Exam PM C is correct because the requirement under Standard IV(C)–Responsibilities of Supervisors does not include any reference to industry standards. Standard IV(C) requires supervisors to instruct those subordinate to whom supervision is delegated about detection meth- ods to prevent violations of laws, rules, regulations, firm policies, and the CFA Institute Code and Standards. A is incorrect because the requirement under Standard  IV(C)–Responsibilities of Supervisors includes detection of any violation of firm policies. B is incorrect because a supervisor’s responsibilities under Standard  IV(C)– Responsibilities of Supervisors include instructing those subordinates to whom super- vision is delegated about methods to prevent and detect violations of laws, rules, regulations, firm policies, and the Code and Standards. Laws would also include legal restrictions. Guidance for Standards I–VII LOS b 9 On a flight to Europe, Romy Haas, CFA, strikes up a conversation with a fellow passenger, Vincent Trujillo. When Trujillo learns that Haas is in the investment profession, he asks about the CFA designation. Haas tells him the following about the CFA designation: Statement 1 Individuals who have completed the CFA Program have the right to use the CFA designation. Statement 2 The CFA designation is globally recognized, which is why I use it as part of my firm’s name. Statement 3 CFA charterholders must satisfy membership requirements to continue using the designation. In explaining the use of the CFA designation, Haas least likely violated the CFA Institute Standards of Professional Conduct concerning which of the following statements? A Statement 1 B Statement 2 C Statement 3 C is correct because according to Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program this is an accurate statement concerning the CFA designation. A is incorrect because according to Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program completion of the CFA Program is not the only requirement for use of the CFA designation as individuals must also have the required years of acceptable work experience. B incorrect because according to Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program the designation must not be used as part of a firm’s name. Guidance for Standards I–VII LOS b Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program

2019 Level I Mock Exam PM 7 10 Tonya Tucker, CFA, is a financial analyst at Bowron Consolidated. Bowron has numerous subsidiaries and is actively involved in mergers and acquisitions to expand its businesses. Tucker analyzes a number of companies, including Hanchin Corporation. When Tucker speaks with the CEO of Bowron, she indicates that many of the companies she has looked at would be attractive acquisition targets for Bowron. After her discussion with the CEO, Tucker purchases 100,000 shares of Hanchin Corporation at $200 per share. Bowron does not have any pre-c­ learance procedures, so the next time she meets with the CEO, Tucker mentions she owns shares of Hanchin. The CEO thanks her for this information but does not ask for any details. Two weeks later, Tucker sees a company-­wide email from the CEO announcing Bowron’s acquisition of Hanchin for $250 a share. With regards to her purchase of Hanchin stock, Tucker least likely violated the CFA Institute Standards of Professional Conduct concerning: A Loyalty. B Priority of Transactions. C Material Nonpublic Information. C is correct because there is no indication the analyst had access to material nonpublic information and was in violation of Standard  II(A)–Material Nonpublic Information. Specifically, Tucker did not have information concerning any decision by Bowron to acquire Hanchin stock since she is not a part of the decision-m­ aking team at Bowron, which determines the companies it plans to take over. The analyst had indicated numer- ous companies were viable options for takeover, and she did not single out any one company in particular. A is incorrect because even though the company does not have a stock pre-­clearance procedure, trading the stock of a company the analyst recommended as an acquisition candidate is an act which violates Standard IV(A)–Loyalty, as she did not give her employer the opportunity to take advantage of her skill/recommendation prior to buying the shares for her own portfolio. B is incorrect because there has been a violation of Standard  VI(B)–Priority of Transactions, which requires that investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner despite the fact that there are no stock pre-­clearance procedures at Bowron. Guidance for Standards I–VII LOS b Standard  II(A)–Material Nonpublic Information, Standard  IV(A)–Loyalty, Standard  VI(B)–Priority of Transactions 11 Thomas Turkman recently hired Georgia Viggen, CFA, as a portfolio manager for North South Bank. Although Viggen worked many years for a competitor, West Star Bank, the move was straightforward since she did not have a non-­ compete agreement with her previous employer. Once Viggen starts working for Turkman, the first thing she does is to bring a trading software package she developed and used at West Star to her new employer. Using public informa- tion, Viggen contacts all of her former clients to convince them to move with her to North South. Viggen also convinces one of the analysts she worked with at West Star to join her at her new employer. Viggen most likely violated the CFA Institute Code of Ethics and Standards of Professional Conduct concerning her actions involving:

8 2019 Level I Mock Exam PM A clients. B the analyst. C trading software. C is correct because the portfolio manager violated Standard IV(A)–Loyalty by taking proprietary trading software from her former employer. Although the manager created the software, it was during a period of time when West Star employed her, so the soft- ware is not her property to take with her to her new employer. The member contacted clients using public information, so she did not violate Standard IV(A)–Loyalty. Because Viggen was not obligated to abide by a non-­compete agreement that would likely restrict recruitment of former colleagues, Viggen is most likely free to recruit the analyst from his former employer. A is incorrect because the member did not contact clients using information from her previous employer so she did not violate Standard IV(A)–Loyalty by these actions. Contacting former clients for any reason through the use of client lists or other information taken from a prior employer without permission would be a violation of the standard because client records are the property of the firm. B is incorrect because West Star does not have any non-­compete agreements so the analyst is free to seek employment elsewhere. Guidance for Standards I–VII LOS b Standard IV(A)–Loyalty 12 Margie Germainne, CFA, is a risk management consultant who has been asked by a small investment bank to recommend policies to prevent bank employees from front-r­ unning client orders. These clients generally invest in one or more of the bank’s large cap equity unit trusts. To ensure compliance with the CFA Institute Standards of Professional Conduct, Germainne should least likely rec- ommend which of the following? Employees should be restricted from trading: A equity related securities. B without prior permission. C during established time periods. A is correct because while Standard VI(B)–Priority of Transactions is designed to prevent any potential conflict of interest or the appearance of a conflict of interest with respect to personal transactions, it does not ban employees from trading securities. A ban on all equity related securities could be excessively restrictive to employees and unnecessary if appropriate personal transaction policies and procedures are in place. B is incorrect because requiring staff members to receive prior permission for personal trading (preclearance procedures) is a recommended practice [Standard VI(B)–Priority of Transactions]. C is incorrect because a restricted trading period is a recommended practice [Standard VI(B)–Priority of Transactions]. Guidance for Standards I–VII LOS c Standard VI(B)–Priority of Transactions

2019 Level I Mock Exam PM 9 13 Kirsten Kelso, CFA, is a research analyst at an independent research firm. Kelso is part of a team of analysts who focus on the automobile industry. Recently, Kelso disagreed with two research sell recommendations written by her team even though she felt confident the research process was properly conducted. In a webcast open to all institutional but not retail clients, Kelso states “even though my name is on the sell reports, these stocks are a buy in part because sales and share prices for both auto companies will rise significantly due to strong demand for their vehicles.” Kelso’s actions would least likely violate which of the following CFA Institute Standards of Professional Conduct? A Fair Dealing B Communication with Clients C Diligence and Reasonable Basis C is correct because the recommendation is based on a reasonable and adequate research process, so the analyst could follow the research team’s opinion, as required by Standard V(A)–Diligence and Reasonable Basis. A is incorrect because the analyst can express her disagreement with the team by documenting her difference of opinion, but Standard III(B)–Fair Dealing requires members and candidates to treat all clients fairly when disseminating investment recommenda- tions or making material changes to prior investment recommendations or when taking investment action. The discussion with institutional clients is inappropriate as the analyst is making selective disclosure. Members and candidates must make every effort to treat all individual and institutional clients in a fair and impartial manner. B is incorrect because the analyst has not separated fact from opinion as required by Standard V(B)–Communication with Clients and Prospective Clients when she makes a verbal buy recommendation on the auto companies. Guidance for Standards I–VII LOS c Standard  III(B)–Fair Dealing, Standard  V(A)–Diligence and Reasonable Basis, Standard  V(B)– Communication with Clients and Prospective Clients 14 Chris Rodriguez, CFA, is a portfolio manager at Nisqually Asset Management, which specializes in trading highly illiquid shares. Rodriguez has been using Hon Securities Brokers almost exclusively when making transactions for Nisqually clients, as well as for his own relatively small account. Hon always executes Rodriguez’s personal trades at a more preferential price than for Rodriguez’s client’s accounts. This occurs regardless of whether or not Rodriguez personally trades before or after clients. Rodriguez should least likely do which of the following in order to comply with the CFA Institute Code of Ethics and Standards of Professional Conduct? A Eliminate the exclusive trading arrangement. B Trade client accounts before his own account. C Average trade prices across all trading accounts. C is correct because Rodriguez is in violation of Standard IV(A)–Loyalty, which requires, in matters related to their employment, members and candidates to act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer. Rodriguez

10 2019 Level I Mock Exam PM should not accept the special treatment from Hon, and he should seek such favors for the clients of Nisqually, specifically the lower costs Rodriguez has been getting for his transactions. Rodriguez should not average transaction costs, as his clients should be given the lower preferential prices according to Standard III(A)–Loyalty Prudence and Care. A is incorrect because Hon is favoring Rodriguez’s personal trading account, most likely as an inducement for him to trade client accounts at Hon, which is a violation by Rodriguez of Standard  IV(A)–Loyalty, which requires, in matters related to their employment, members and candidates to act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer. By trading ahead of clients the member has also violated Standard  VI(B)–Priority of Transactions, and changing this procedure is necessary. Investment transactions for clients and employers must have priority over investment transactions in which a member or candidate is the beneficial owner. Front-­running transactions is considered unethical behavior because of the importance of the duty of loyalty investment professionals owe to their clients and the fact that this duty is compromised whenever professionals place their personal interests before those of their clients. B is incorrect because the member has violated Standard VI(B)–Priority of Transactions by trading ahead of clients, and changing this procedure is necessary. Investment transactions for clients and employers must have priority over investment transactions in which a member or candidate is the beneficial owner. Front-­running transactions is considered unethical behavior because of the importance of the duty of loyalty investment professionals owe to their clients and the fact that this duty is compromised whenever professionals place their personal interests before those of their clients. Guidance for Standards I–VII LOS c Standard IV(A)–Loyalty, Standard VI(B)–Priority of Transactions 15 Which of the following statements related to why the GIPS standards were cre- ated is least likely correct? GIPS standards were created to: A provide clients certainty in what is presented and allow them to make rea- sonable comparisons. B identify a set of ethical principles for firms to follow in calculating and pre- senting historical investment results. C establish a standardized, industry wide approach for investment firms to follow. A is correct. The GIPS standards were created to ensure fair representation and full disclosure of investment performance, not to provide certainty in what is presented. B is incorrect because this is a correct statement as to why the GIPS standards were created. C is incorrect because this is a correct statement as to why the GIPS standards were created. Introduction to the Global Investment Performance Standards (GIPS) LOS a 16 Which of the following statements concerning the Global Investment Performance Standards (GIPS) is most likely correct? A Clients or prospective clients benefit from the Standards because the histor- ical track record of compliant firms is accurate and precise.

2019 Level I Mock Exam PM 11 B The Standards eliminate the need for in-d­ epth due diligence by investors. C Compliance with the Standards enhances the credibility of investment man- agement firms. C is correct. Compliance with the GIPS standards enhances the credibility of investment management firms. A is incorrect. The GIPS standards do not ensure that the historical track record of com- pliant firms is accurate and precise, only that the record is complete and fairly presented. B is incorrect because the Standards do not eliminate the need for in-­depth due diligence by investors. Introduction to the Global Investment Performance Standards (GIPS) LOS a 17 Which of the following statements does not accurately represent the GIPS stan- dards concerning the fundamentals of compliance? GIPS standards: A promote fair competition amongst investment management firms in all mar- kets requiring a common fee structure. B ensure consistent, accurate investment performance data in areas of report- ing, records, marketing, and presentations. C obtaining global acceptance of calculation and presentation standards in a fair, comparable format with full disclosure. A is correct. The GIPS standards do not promote fair competition among investment management firms in all markets by requiring a common fee structure. B is incorrect. Ensuring consistent, accurate investment performance data in areas of reporting, records, marketing, and presentations accurately represents the GIPS standards concerning the fundamentals of compliance. C is incorrect. Obtaining global acceptance of calculation and presentation standards in a fair, comparable format with full disclosure accurately represents the GIPS standards concerning the fundamentals of compliance The GIPS Standards LOS a 18 The belief that one’s ethical standards are above average is most likely a reflec- tion of which of the following behavioral biases? A Overconfidence B Short-­term focus C Situational influence A is correct. The belief that one’s ethical standards are above average illustrates an over- confidence bias. An overconfidence bias will most likely lead individuals to overestimate the morality of their own behavior and can lead to a failure to consider important inputs and variables needed to make the best ethical decisions.

12 2019 Level I Mock Exam PM B is incorrect. A short-t­ erm focus is an aspect of situation influences. Our brains more easily and quickly identify, recognize and consider short-t­ erm situational influences versus longer-­term considerations. Long-t­ erm considerations have less immediate consequences making them less obvious as factors to consider in a decision and therefore, less likely to influence our overall decision making. C is incorrect. Situational influences are external factors that shape our thinking, decision making, and behavior. Learning to recognize a situational influence is critical to making good decisions however it is not a behavioral bias. Ethics and Trust in the Investment Profession LOS c Section 4 19 Examples of the beneficial features of using an ethical decision-m­ aking frame- work least likely includes analyzing: A the best course of action when alternatives are available. B the decision maker’s perspective of contemplated actions. C a broader picture from a long-t­erm point of view. B is correct. An ethical decision-m­ aking framework helps a decision maker see the situation from multiple perspectives, not just from her personal perspective, and pay attention to aspects of the situation that may be less evident if a short-­term, self-f­ ocused perspective is applied. A is incorrect because an ethical decision making framework helps a decision-­maker see the best course of action when alternatives are available. C is incorrect because an ethical decision making framework helps a decision-m­ aker see a situation from multiple perspectives and pay attention to aspects of the situation that may be less evident if a short-­term, not a long -term, self-­focused perspective is applied. Ethics and Trust in the Investment Profession LOS f Section 7 20 An investor wants to maximize the possibility of earning at least 5% on her investments each year. Portfolio Expected Standard Roy’s Safety-­First Ratio Return Deviation 1 0.35 2 0.64 3 22% 40% ?? Using Roy’s safety-f­irst criterion, the most appropriate choice for the investor is portfolio: A 3. B 2. C 1.

2019 Level I Mock Exam PM 13 B is correct. The portfolio with the highest safety-­first ratio (SFRatio) is preferred. The SFRatio is calculated by subtracting the threshold return (RL) from the expected return [E(RP)] and dividing by the standard deviation (σP). SFRatio = [E(RP) – RL]/σP. For the choices given: Portfolio 1 Portfolio 2 Portfolio 3 Roy’s Safety First 0.35 0.64 0.425 = [(22 – 5)/40] Criterion Portfolio 2 has the highest SFRatio, so it is the most appropriate choice. C is incorrect because 0.35 is less than 0.64. A is incorrect because 0.425 is less than 0.64. Common Probability Distributions LOS m Section 3.3 21 Compared with historical simulation, Monte Carlo simulation is most appropri- ate when: A probability distributions are unavailable. B “what if ” analysis is required. C analytical methods are required. B is correct. Monte Carlo simulation lends itself to “what if” analysis and requires the user to provide a probability distribution or distributions. It can be a complement to analytical methods. A is incorrect. Monte Carlo simulation requires probability distribution C is incorrect. Monte Carlo simulation can be a complement to analytical methods. Analytical methods provide precise results, whereas Monte Carlo simulation does not. Common Probability Distributions LOS q Section 4 22 An investor purchases one share of stock for $85. Exactly one year later, the company pays a dividend of $2.00 per share. This is followed by two more annual dividends of $2.25 and $2.75 in successive years. Upon receiving the third dividend, the investor sells the share for $100. The money-­weighted rate of return on this investment is closest to: A 7.97%. B 8.15%. C 8.63%.

14 2019 Level I Mock Exam PM B is correct. The money-­weighted rate of return is the internal rate of return (IRR) of the cash flows associated with the investment. The following figure represents the timeline for the problem: Years: 0 1 2 3 Cash Flows (in $): (85) (2.00) (2.25) (102.75) Using the cash flow (CF) function of a financial calculator: CF0 = –85, CF1 = 2, CF2 = 2.25, CF3 = 102.75; and solving for IRR: IRR = 8.15%. A is incorrect. It adds all three dividends together and (incorrectly) calculates the HPR of the investment as (2 + 2.25 + 102.75)/85 = 1.25882353. Then the third root of this number is taken and 1 is subtracted. The result is 7.97%. C is incorrect. It is calculated by subtracting 1 from 1.25882353 (see Justification A) and dividing the remainder by 3. The result is 8.63%. Discounted Cash Flow Applications Section 3.1 LOS d 23 A one-­tailed hypothesis testing has a p-value for a test statistic of 3%. An ana- lyst would not reject the null hypothesis at a significance level of: A 0.01. B 0.05. C 0.10. A is correct. By the definition of p-value, 0.03 is the smallest level of significance at which the null hypothesis can be rejected. An analyst cannot reject the null hypothesis at the 0.01 significance level. B is incorrect. As explained in choice A C is incorrect. As explained in choice A. Hypothesis Testing LOS f Section 2 24 Event X and Event Y are independent events. The probability of X is 0.2 [P(X) = 0.2] and the probability of Y is 0.5 [P(Y) = 0.5]. The joint probability of X and Y, P(XY), is closest to: A 0.7. B 0.3. C 0.1. C is correct. Given that X and Y are independent, their joint probability is equal to the product of their individual probabilities. In this case: P(XY) = P(X)P(Y) = 0.2 × 0.5 = 0.1. A is incorrect; it is the sum of the two individual probabilities (i.e., 0.5 + 0.2 = 0.7).

2019 Level I Mock Exam PM 15 B is incorrect; it is the difference between the two individual probabilities (i.e., 0.5 – 0.2 = 0.3). Probability Concepts LOS f Section 2 25 An investor in Abco stock forecasts the probability that Abco exceeded, met, or fell short of consensus expectations for free cash flow (FCF) during the prior quarter: ● P(FCF exceeded consensus) = 0.50 ● P(FCF met consensus) = 0.35 ● P(FCF fell short of consensus) = 0.15 While waiting for Abco to release last quarter’s FCF data, the investor learns that Abco will acquire a competitor. Believing that the upcoming acquisition makes it more likely that last quarter’s FCF will exceed the consensus, the inves- tor generates a list of FCF events that may have influenced the acquisition: ● P(Acquisition | FCF exceeded consensus) = 0.40 ● P(Acquisition | FCF met consensus) = 0.25 ● P(Acquisition | FCF fell short of consensus) = 0.35 Using Bayes’ Formula, calculate the probability that Abco is likely to exceed consensus FCF expectations for last quarter given the acquisition. P(FCF exceeded consensus | Acquisition) is closest to: A 34%. B 59%. C 27%. B is correct. The updated probability P(FCF exceeded consensus | Acquisition) is 59%. 1 Calculate the unconditional probability that Abco will acquire the competitor firm: P(Acquisition) = (0.50 × 0.40) + (0.35 × 0.25) + (0.15 × 0.35) = 0.34, or 34%. 2 Calculate the updated probability that Abco exceeded consensus expectations for FCF given that they acquire the competitor firm: P(FCF exceeded consensus | Acquisition) = [P(Acquisition | FCF exceeded consensus)/P(Acquisition)] × P(FCF exceeded consensus) = (0.40/0.34) × (0.50) = 0.59 or 59%. A is incorrect because 34% is the unconditional probability that Abco acquires the competitor firm: P(Abco acquires) = (0.50 × 0.40) + (0.35 × 0.25) + (0.15 × 0.35) = 0.34, or 34%.

16 2019 Level I Mock Exam PM C is incorrect because the updated probability was calculated in error: [P(Acquisition | FCF exceeded consensus) × P(Acquisition)]/P(FCF exceeded consensus) = (0.40 × 0.34)/(0.50) = 0.27 or 27% Probability Concepts LOS n Section 8.2 26 An analyst applies four valuation screens to a set of potential investments. The screens are independent of each other. Valuation Screen Probability of Passing 1 0.65 2 0.45 3 0.40 4 0.30 If there are 1,200 potential investments, the number expected to simultaneously pass all four screens is closest to: A 360. B 97. C 42. C is correct. As the screens are independent, the probability of passing all four simul- taneously is the product of their respective probabilities: P(ABCD) = P(A)P(B)P(C)P(D) where P(A) = 0.65 and is the probability of passing valuation screen 1 P(B) = 0.45 and is the probability of passing valuation screen 2 P(C) = 0.40 and is the probability of passing valuation screen 3 P(D) = 0.30 and is the probability of passing valuation screen 4 P(ABCD) = 0.65 × 0.45 × 0.40 × 0.30 = 0.0351. Given 1,200 potential investments, approximately 1,200 × 0.0351 = 42.12 ~ 42 will pass the screens. A is incorrect. It uses only the smallest of the given probabilities as in 1,200 × 0.30 = 360. B is incorrect. It subtracts the given probabilities from 1.00 and uses the product of these values: [(1 – 0.65) × (1 – 0.45) × (1 – 0.40) × (1 – 0.30)] × 1,200 = (0.35 × 0.55 × 0.60 × 0.70) × 1,200 = 0.08085 × 1,200 = 97.02 ~ 97. Probability Concepts LOS e, f Section 2 Financial Statement Analysis: Applications LOS d Section 5 27 An analyst gathered the following information about a stock index:

2019 Level I Mock Exam PM 17 Mean net income for all companies in the index $2.4 million Standard deviation of net income for all companies in the index $3.2 million If the analyst takes a sample of 36 companies from the index, the standard error of the sample mean is closest to: A $400,000. B $533,333. C $88,889. B is correct. The standard error of the sample mean is equal to the population standard deviation (σ) divided by the square root of the number of observations in the sample (n): σX = σ n = $3,200,000 36 = $533,333 A is incorrect. It uses the following formula: $2,400,000 36 = $400,000. C is incorrect. It uses the following formula: $3,200,000/36 = $88,889. Sampling and Estimation LOS f Section 3.1 28 The figure below shows the histogram for the distribution of weekly returns on an index. Frequency Return Intervals The median of the returns on the index, if compared to the mean, will most likely be: A smaller. B equal. C greater.

18 2019 Level I Mock Exam PM A is correct. The histogram clearly shows that the return distribution of the index is positively skewed (skewed to the right) and is unimodal (it has one most frequently occurring value). For a positively skewed unimodal distribution, the median is always less than the mean. B is incorrect. By looking at the histogram, it is clear that the return distribution of the index is positively skewed (skewed to the right) and is unimodal (it has one most frequently occurring value). For a positively skewed unimodal distribution, the median is always less than the mean. C is incorrect. By looking at the histogram, it is clear that the return distribution of the index is positively skewed (skewed to the right) and is unimodal (it has one most frequently occurring value). For a positively skewed unimodal distribution, the median is always less than the mean. Statistical Concepts and Market Returns LOS d, j, k Sections 4.1, 5.3, 8 29 A technical analyst observes a head and shoulders pattern in a stock she has been following. She notes the following information: Head price $83.50 Shoulder price $72.00 Neckline price $65.75 Current price $64.00 Based on this information, her estimate of the price target is closest to: A $59.50. B $48.00. C $44.50. B is correct. Price target = Neckline − (Head − Neckline). In this example, Price target = $65.75 − ($83.50 − $65.75) = $65.75 – $17.75 = $48.00. A is incorrect because 59.50 = Neckline – (Shoulder – Neckline) = 65.75 – (72 – 65.75). C is incorrect because 44.50 = Current Price – (Head – Current Price) = 64 – (83.50 – 64). Technical Analysis LOS d Section 3.3.1.3 30 The minimum rate of return an investor must receive in order to accept an investment is best described as the: A internal rate of return. B required rate of return. C expected return.

2019 Level I Mock Exam PM 19 B is correct. The required rate of return is the minimum rate of return an investor must receive in order to accept an investment. A is incorrect. The required rate of return is the minimum rate of return an investor must receive in order to accept an investment. The internal rate of return is the discount rate that makes net present value equal to zero C is incorrect. The required rate of return is the minimum rate of return an investor must receive in order to accept an investment. The expected return is based on the expected value of a random variable and is not the minimum rate of return an investor must receive in order to accept an investment (i.e., the expected return could also be negative). The Time Value of Money LOS a Section 2 31 A borrower is considering three competing mortgage loan offers from her bank. The amount borrowed on the mortgage is $100,000 with monthly compounding. Mortgage Type Stated Annual Interest Year in Which Rate at Initiation of the Rate First Adjusts Loan 30-­year fixed rate 5.000% N/A 20-­year fixed rate 4.385% N/A 30-y­ ear adjustable-r­ ate mortgage (ARM) 3.750% 3 The rate on the ARM resets at the end of Year 3. Assuming the ARM is perma- nently reset at 5.500% (i.e., the remaining balance on the loan is assumed to be repaid with a 5.500% stated annual interest), which of the three loans will have the smallest monthly payment after the rate reset at the end of Year 3? A 30-­year fixed-­rate loan B 20-­year fixed-­rate loan C 30-­year ARM A is correct. The timeline for the 30-y­ ear fixed rate is as follows: Months: 0 1 ... 36 ... 360 (X) ... X ... (X) Cash Flows: $100,000 FV = 0 where X is the monthly payment for all 360 months. 240 The timeline for the 20-y­ ear fixed rate is as follows: (Y) FV = 0 Months: 0 1 ... 36 ... (Y) ... Y ... Cash Flows: $100,000 where Y is the monthly payment for all 240 months. The timeline for the 30-y­ ear ARM is as follows:

20 2019 Level I Mock Exam PM Months: 0 1 ... 36 37 ... 360 ... (K) Cash Flows: $100,000 (Z) ... Z K FV = 0 where Z is the monthly payment for the first 36 months (three years) and K is the monthly payment for months 37 to 360 (payment after Year 3). The loan payments are calculated using a financial calculator. Loan Calculation of Monthly Initial Loan Payment Payments Payment after Three Years ($) ($) 30-­year X is found as follows: 536.82 536.82 fixed N = 12 × 30 = 360, I/Y = (5/12) = 0.41667, PV = 100,000, FV = 626.46 626.46 20-­year 0, calculate PMT = 536.82. fixed 463.12 (this 559.16 (this cor- Y is found as follows: corresponds responds to K) 30-­year N = 12 × 20 = 240, I/Y = ARM (4.385/12) = 0.36542, PV = to Z) 100,000, FV = 0, calculate PMT = 626.46. Z is found as follows: N = 12 × 30 = 360, I/Y = (3.75/12) = 0.31250, PV = 100,000, FV = 0, calculate PMT = 463.12. K is found in two steps: First, the balance at end of Year 3 is found: N = 12 × 27 = 324, I/Y = (3.75/12) = 0.31250, FV = 0, PMT = 463.12, calculate PV = 94,271.43. Then, K is calculated as follows: N = 324, I/Y = (5.5/12) = 0.45833, PV = 94,271.43, FV = 0, calculate PMT = 559.16. After Year 3, the 30-y­ ear fixed-r­ate loan has the lowest payment: 536.82 < 559.16 < 626.46. Note: Numbers may differ slightly from those given above because of rounding. B is incorrect; 536.82 < 559.16 < 626.46. C is incorrect; 536.82 < 559.16 < 626.46. The Time Value of Money LOS d, e, f Section 7.3 32 A New Zealand traveler returned from Singapore with SGD7,500 (Singapore dollars). A foreign exchange dealer provided the traveler with the following quotes:

2019 Level I Mock Exam PM 21 Ratio Spot Rates USD/SGD NZD/USD 1.2600 0.7670 USD: US dollar; NZD: New Zealand dollar The amount of New Zealand dollars (NZD) that the traveler would receive for his Singapore dollars is closest to: A NZD7,248. B NZD4,565. C NZD7,761. A is correct. The NZD/SGD cross-­rate is NZD/USD × USD/SGD = 0.7670 × 1.2600 = 0.9664. The traveler will receive: NZD0.9664 per SGD; NZD0.9664 × SGD7,500 = NZD7,248. B is incorrect. It calculates NZD/SGD incorrectly by inverting USD/SGD (0.7670  × 1/1.26 = 0.6087) and multiplying by 7,500 = 4,565 NZD. This is equivalent to incorrectly first converting to USD (1/1.26 × 7,500 SGD) to give 5,952 USD and then converting to NZD ($5,952 × 0.7670 NZD/$ = 4,565 NZD). C is incorrect. It calculates the cross rate correctly, but divides it into 7,500: 7,500/0.9664 = 7,761. Currency Exchange Rates LOS d Section 3.2 33 A dealer report includes the following exchange rate details: Spot Rate Expected Change over Next Year USD/EUR 1.30 1.75% CAD/USD 0.95 –0.25% CHF/EUR 1.22 0.75% The expected CAD/CHF cross rate in one year is closest to: A 1.04. B 0.98. C 1.02. C is correct.

22 2019 Level I Mock Exam PM Spot Expected Appreciation Expected Spot Rate Rate in One Year USD/EUR 1.30 1.75% 1.323 CAD/USD 0.95 –0.25% 0.948 CHF/EUR 1.22 0.75% 1.229 CAD/CHF = (USD/EUR) × [(CAD/USD)/ = 1.020 (CHF/EUR)] A is incorrect because the cross rates are calculated incorrectly: ∑CAD/CHF = SCCHAFD × 1 + (expected appreciation of the 3 exchange rates)  = 1.012 × [1 + (1.75% – 0.25% + 0.75%)]  = 1.012 × (1 + 2.25%)  = 1.035 B is incorrect. It calculates the Swiss Franc (CHF) relative to the Canadian dollar (CAD): (CHF/EUR)/[(USD/EUR)/(CAD/USD)] = 1.229/(1.323/0.948) = 0.881. Currency Exchange Rates LOS d Section 3.2 34 Which of the following statements is most accurate? For a country to gain from trade, it must have: A economies of scale or lower labor costs. B an absolute advantage. C a comparative advantage. C is correct. A comparative advantage arises if one entity can produce an item at a lower opportunity cost than another. An absolute advantage in producing a good (or service) arises if one entity can produce that good at a lower cost or use fewer resources in its production than its trading partner. Even if a country does not have an absolute advan- tage in producing any of its goods, it can still gain from trade by exporting the goods in which it has a comparative advantage. The country with the lower opportunity cost (with the comparative advantage) should specialize and produce its low opportunity cost item, and the other country should produce the high opportunity cost item, trading the goods between each other to make both better off. A is incorrect. Economies of scale or lower labor costs will likely result in a lower cost of production, but only a comparative advantage is necessary to benefit from trade. B is incorrect. An absolute advantage in producing a good (or service) arises if one country is able to produce that good at a lower cost or use fewer resources in its produc- tion than its trading partner. It is the lower opportunity cost that one country has that is the reason that one country should specialize in order to gain from trade. International Trade and Capital Flows LOS c Section 2.4.1 35 A country having a current account deficit most likely will still be able to con- sume more output than it produces by:

2019 Level I Mock Exam PM 23 A adjusting interest rates to stimulate higher domestic savings. B restricting foreign direct investment. C increasing its net foreign liabilities. C is correct. A current account deficit must be offset by a capital account surplus. Only by borrowing money from foreigners can a country have a current account deficit and consume more output than it produces. An increase in net foreign liabilities is the result of borrowing from foreigners. B is incorrect. Restricting foreign direct investment would have a negative effect on the capital account surplus and the country’s ability to increase its consumption. A is incorrect. A current account deficit is consistent with low domestic savings. For the capital account to achieve a surplus, investments should exceed savings. International Trade and Capital Flows LOS h Sections 4.3, 4.4 Currency Exchange Rates LOS j Section 5 36 Which of the following statements regarding the money creation process in fractional reserve banking is correct? A The reserve requirement is negatively related to the quantity of money created. B The reserve requirement is positively related to the availability of credit. C The money multiplier is unaffected by the reserve requirement. A is correct. The amount of money that the banking system creates through fractional reserve banking is a function of the money multiplier, which is expressed as 1 divided by the reserve requirement. Therefore, the smaller the reserve requirement, the greater the money multiplier effect on money creation. B is incorrect because the reserve requirement multiplied by the deposit amount results in the amount of asset reserve that the bank is required to hold relative to the deposit liability. The higher the reserve requirement, the lower the net amount of the deposit (equal to the total deposit amount less the amount of required reserve) available for lending. C is incorrect because the money multiplier is expressed as 1 divided by the reserve requirement. A higher reserve requirement results in a lower money multiplier, whereas a lower reserve requirement results in a higher money multiplier. Monetary and Fiscal Policy LOS c Section 2.1.2 37 In an effort to influence the economy, a central bank conducted open market activities by selling government bonds. This action implies that the central bank is most likely attempting to: A contract the economy by reducing bank reserves.

24 2019 Level I Mock Exam PM B expand the economy through a lower policy interest rate. C contract the economy through a lower policy interest rate. A is correct. Selling government bonds results in a reduction of bank reserves and reduces their ability to lend, causing a decline in money growth through the multiplier mechanism and hence a contraction in the economy. B is incorrect. Central bank selling of bonds is not expansionary. C is incorrect. Central bank selling of bonds will reduce the money supply through its impact on bank reserves, which will result in a higher, not lower, interest rate. Monetary and Fiscal Policy LOS h, k, m Sections 2.3.2.1, 2.3.2.2 38 The effectiveness of infrastructure spending as a near-t­erm fiscal stimulant would be least constrained by the: A impact lag. B action lag. C recognition lag. C is correct. Recognition lag refers to the time required before policymakers realize that a policy action is required because data appear with a considerable lag and are subject to substantial revision. A policy action to spend on infrastructure would occur at the conclusion of this lag and, as a result, the recognition lag is not a constraint on any specific type of policy action. A is incorrect because the impact lag refers to the length of time required for a policy action to become evident in the economy. When spending on an infrastructure project begins, there will be a delay in judging its effects and making any related adjustments to more effectively stimulate the economy due to the impact lag. B is incorrect because the action lag refers to the length of time required to actually implement a policy action once it has been decided on. In the case of infrastructure spending, it may take several months of planning before the project is put into action, thereby constraining its near-­term stimulative effect. Monetary and Fiscal Policy LOS r Section 3.3.2 39 A firm in a market environment characterized by monopolistic competition is most likely to: A continue to experience economic profit in the long run. B have a well-d­ efined supply function reflecting its marginal and average costs. C have many competitors each following its own product differentiation strategy.

2019 Level I Mock Exam PM 25 C is correct. As the name implies, monopolistic competition is a hybrid market struc- ture. The most distinctive factor in monopolistic competition is product differentiation. Although the market is made up of many firms that compose the product group, each producer attempts to distinguish its product from that of the others, and product dif- ferentiation is accomplished in a variety of ways. A is incorrect. Just as with the perfectly competitive market structure, with relatively low entry costs, more firms will enter the market and lure some customers away from the firm making an economic profit. The loss of customers to new entrant firms will drive down the demand for all firms producing similar products. In the long run for the monopolistically competitive firm, economic profit will fall to zero. B is incorrect. In monopolistic competition, there is no well-­defined supply function. The information used to determine the appropriate level of output is based on the inter- section of MC and MR. However, the price that will be charged is based on the market demand schedule. The firm’s supply curve should measure the quantity the firm is willing to supply at various prices. That information is not represented by either marginal cost or average cost. The Firm and Market Structures LOS a, b, c Section 4 40 Six companies in an industry have the following market shares: Company ABCDE F Market Share (%) 30 25 16 12 10 7 If Companies D and F merge into a new Company, G, the industry’s three-­ company concentration ratio would be closest to: A 72%. B 74%. C 71%. B is correct. The concentration ratio for the top three companies would be 74%: A (30%) + B (25%) + G (12% + 7%). A is incorrect. 72% is the concentration ratio of the top three companies if the two smallest merge: A (30%) + B (25%) + [E (10%) + F (7%)]. C is incorrect. 71% is the concentration ratio of the original top three companies: A (30%) + B (25%) + C (16%). The Firm and Market Structures LOS g Section 7.2 41 In the short run, a firm operating in a perfectly competitive market will most likely avoid shutdown if it is able to earn sufficient revenue to cover which of the following costs? A Fixed B Marginal

26 2019 Level I Mock Exam PM C Variable C is correct. Shutdown is defined as a situation in which the firm stops production but still confronts the payment of fixed costs in the short run. In the short run, a business can operate at a loss as long as it covers its variable costs even though it is not earning sufficient revenue to cover fixed costs. If variable costs cannot be covered in the short run (P < AVC), the firm will shut down operations and simply absorb the unavoidable fixed costs. B is incorrect. Marginal cost is the incremental cost of producing one more unit and can be calculated as either (Δ total cost/Δ quantity) or (Δ total variable cost/Δ quantity). A is incorrect. In the short run, a business can operate at a loss as long as it covers variable costs even though it is not earning sufficient revenue to cover fixed costs. Topics in Demand and Supply Analysis LOS e Section 3.2.7 42 Assuming all other factors remain unchanged, which of the following changes would most likely cause a simultaneous increase in the participation ratio and a decrease in the unemployment rate? A A decrease in the number of unemployed people B A decrease in the total population of working-a­ ge people C An increase in the number of people included in the labor force C is correct. The participation ratio (or activity ratio) is the ratio of the number of people in the labor force to the total population of working-a­ ge people, and the unemployment rate is the ratio of the number of unemployed to the number of people in the labor force. The labor force is the numerator in the participation ratio, and the denominator is the unemployment rate. Therefore, assuming all else remains unchanged, an increase in the number of people included in the labor force would cause the participation ratio to increase and unemployment rate to decrease. A is incorrect. Although a decrease in the total number of unemployed people would decrease the unemployment rate, this would not have a direct effect on the participa- tion rate. B is incorrect. Although a decrease in the total population of working age people would increase the participation rate if the size of the labor force remained unchanged, this would have no direct effect on the unemployment rate. Understanding Business Cycles LOS d Section 4.1 43 After noting positive changes in the aggregate index of coincident economic indicators, an increase in the ratio of consumer installment debt to income would most likely help confirm that an expansion is: A forthcoming. B underway. C ending.

2019 Level I Mock Exam PM 27 B is correct. The ratio of consumer installment debt to income is a lagging indicator. An increase in it, by itself, would be evidence that an upturn is already underway. This would confirm the implication of positive changes in coincident indicators that an expansion is in place. A is incorrect. Leading indicators indicate what is coming, but the ratio of consumer installment debt to income is a lagging indicator. The reason it is a lagging indicator is because consumers only borrow heavily when they are confident in the economy. C is incorrect. Although the ratio of consumer installment debt to income is a lagging indicator, it is more directly indicating that an upturn has been underway, not that the expansion is over because consumers only borrow heavily when they are confident in the economy. Understanding Business Cycles LOS i Section 5 44 Selected information for a company and its industry’s average return on equity (ROE) is provided: Company (£) Industry (£) Earnings before interest 76,000 EBIT margin 0.28 and taxes (EBIT) Pretax profit 66,400 Interest burden 0.70 Net income 44,500 Tax burden 0.67 Sales 400,000 Total asset turnover 0.71 Total assets 524,488 Financial leverage 1.89 Total equity 296,488 ROE 15.0% 17.6% Which of the following is most likely a contributor to the company’s inferior ROE compared with that of the industry? The company’s lower: A financial leverage. B tax burden ratio. C interest burden ratio. A is correct. Compare the three specified components from the five-w­ ay DuPont analysis: Calculation Company Industry Tax burden ratio (Net income/EBT) 44,488/66,400 = 0.67 0.67 (Same as industry) 1.89 Financial leverages (Total assets/ 0.70 Equity) 524,488/296,488 = 1.77 Interest burden (Lower than industry) ratio (EBT/EBIT) 66,400/76,000 = 0.87 (Higher than industry) Note: EBT is pre-­tax profit (earnings before tax)

28 2019 Level I Mock Exam PM The lower financial leverage ratio relative to the industry is one of the causes of the company’s poor relative performance. B is incorrect, as per table. C is incorrect, as per table. Financial Analysis Techniques LOS c, d Section 4.6.2 45 When forecasting earnings, an analyst’s best approach is to: A establish a precise forecast based on the results of economic and financial analysis. B calculate a range of possibilities based on the results of financial analysis. C utilize the results of financial analysis and professional judgment. C is correct. Forecasts are not limited to a single point estimate but should involve a range of possibilities. The results of financial analysis are integral to this process, along with judgment of the analysts. A is incorrect. Forecasts should involve a range of possibilities and should not be based solely on economic and financial analysis. B is incorrect. While analysts should derive a range of possibilities, they should not rely solely on financial analysis. Financial Analysis Techniques LOS g Section 8 46 Which of the following is lowest in quality on the spectrum of GAAP conform- ing financial reports? A Aggressive accounting choices B Earnings management C Conservative accounting choices B is correct. Earnings management represents deliberate actions to influence reported earnings and their interpretation. The distinction between earnings management and biased choices is subtle and, primarily, a matter of intent. A is incorrect because aggressive accounting is a biased choice. Biased accounting choices are higher in quality than earnings management on the spectrum of GAAP conforming financial reports. C is incorrect because conservative accounting is a biased choice. Biased accounting choices are higher in quality than earnings management on the spectrum of GAAP conforming financial reports. Financial Reporting Quality LOS b Section 2 to 2.3.1

2019 Level I Mock Exam PM 29 47 Which of the following techniques is most likely to provide a company with the opportunity to inflate earnings? A Reductions in the useful lives of fixed assets B Last-i­n, first-o­ ut (LIFO) liquidation C Increases to tax asset valuation allowances B is correct. The LIFO liquidation of low-c­ ost inventory layers results in the transfer of low inventory costs to the income statement as costs of goods sold. With reduced costs of goods sold, reported earnings are higher. A is incorrect. Reducing the useful lives of fixed assets results in faster depreciation, and hence higher reported depreciation expense and lower reported earnings. C is incorrect. Increases to tax asset valuation allowances are equivalent to asset write-d­ owns, which reduce reported earnings. Financial Reporting Quality LOS h Section 4.2.3 Inventories LOS e Section 4 48 The SEC’s approach to addressing the significant differences in financial report- ing under International Financial Reporting Standards (IFRS) and US GAAP is best described as: A requiring issuers to provide disclosures describing key differences. B mandating that non-U­ S issuers provide a reconciliation to US GAAP. C publicly advocating for global accounting standards and convergence. C is correct. The SEC now advocates for global accounting standards through public announcements, such as its “Statement in Support of Convergence and Global Accounting Standards” (2010). In the past, the SEC had required reconciliations between IFRS and US GAAP, but these requirements were withdrawn in 2008. The SEC now imposes no requirements on its issuers. A is incorrect. Before 2008, issuers were required to provide disclosures in support of the reconciliation from IFRS to US GAAP. B is incorrect. Before 2008, issuers were required to provide a reconciliation from IFRS to US GAAP. Financial Reporting Standards LOS c Section 4 49 Analysts can best address the challenges of comparing financial statements prepared under US GAAP with those prepared under International Financial Reporting Standards (IFRS) by: A referring to the reconciliation from IFRS to US GAAP provided in the notes. B assuming differences are minor given US GAAP and IFRS convergence. C monitoring changes in both sets of standards and interpreting cautiously.

30 2019 Level I Mock Exam PM C is correct. Significant differences still exist between IFRS and US GAAP, and in most cases, analysts will lack the information necessary to make specific adjustments to address these differences. As such, comparisons must be interpreted cautiously. B is incorrect. Significant differences still exist between IFRS and US GAAP, and should not be ignored. A is incorrect. Reconciliations are no longer readily available. The SEC eliminated the reconciliation requirement for companies that prepared their financial statements according to IFRS in 2007. Financial Reporting Standards LOS h Section 7 50 An analyst’s examination of the performance of a company is least likely to include an assessment of a company’s: A assets relative to its liabilities. B profitability. C cash flow generating ability. A is correct. Assessment of performance includes analysis of profitability and cash flow generating ability. The relationship between assets and liabilities is used to assess a company’s financial position, not its performance. B is incorrect. Assessment of performance includes analysis of profitability. C is incorrect. Assessment of performance includes analysis of cash flow generating ability. Financial Statement Analysis: An Introduction LOS a Section 2 51 A company has a building with a net carrying amount of $100,000 and a tax base of $120,000. The tax rate was 20% when the asset was purchased, but it is scheduled to be reduced to 17% this year. Which of the following will the com- pany most likely report related to this building? A Deferred tax asset: $4,000 B Deferred tax asset: $3,400 C Deferred tax liability: $600 B is correct. The deferred tax asset is based on the temporary difference arising from the difference in the carrying value for taxes vs. the financial statements = (120,000 – 100,000) × 17% = 3,400. The rate that should be used is the rate expected when the reversal will occur, which is now the lower rate of 17%. A is incorrect because the old tax rate is used: (120,000 – 100,000) × 20% = 4,000.

2019 Level I Mock Exam PM 31 C is incorrect. It incorrectly nets the tax rates: (100,000 – 120,000) × (20% – 17%) = –600. Income Taxes LOS e Section 3.3 52 A company manufactures aluminum cans for the beverage industry and prepares its financial statements in accordance with International Financial Reporting Standards (IFRS). During its latest full fiscal year, the company recorded the following: Inventory Item Amount € (thousands) Raw material aluminum costs 150,000 Storage of finished cans 15,000 Wasted aluminum materials from abnormal production errors during the year 500 Transportation-­in costs Tax-­related duties 640 Administrative overhead 340 Trade discounts due to volume purchases throughout the year 7,500 520 The total costs included in inventory (in € thousands) for the year are closest to: A €150,980. B €150,460. C €149,820. B is correct. Total inventory costs are as follows: Inventory Item Amount € (thousands) Raw materials 150,000 Transportation-­in 640 Tax-­related duties 340 Less: Trade discounts (520) Total inventory costs 150,460 Abnormal waste, storage of finished goods, and administrative overhead are expensed. A is incorrect because trade discounts of €520 were not subtracted from inventory, giving the incorrect total €150,980. C is incorrect because transportation of €640 was not added to inventory, giving the incorrect total of €149,820. Inventories LOS a Section 2 53 A company purchased a warehouse for €35 million and incurred the following additional costs in getting the warehouse ready for use: ● €2.0 million for upgrades to the building’s roof and windows

32 2019 Level I Mock Exam PM ●● €0.5 million to modify the interior layout to meet their needs (moving walls and doors, inserting and removing partitions, etc.) ●● €0.1 million on an orientation and training session to familiarize employees with the facility The cost to be capitalized to the building account (in millions) is closest to: A €37.6. B €37.5. C €37.0. B is correct. The capitalized cost of the building would include the other costs that are directly attributable to the building and are involved in extending its life or getting it ready to use: € millions Initial cost 35.00 Upgrades to roof and windows 2.00 Modifications to interiors 0.50 Total cost 37.5 A is incorrect. It includes the staff training: 37.5 + 0.1 = 37.6. C is incorrect. It does not include the modifications to the interior: 35 + 2.0 = 37.0. Long-­Lived Assets LOS a Section 2.1 54 The following information is available for an asset purchased at the start of its first year of operations (Year 1): ●● Purchase price: $1.8 million ●● Estimated useful life: 5 years ●● Estimated residual value: $500,000 If the company uses the double declining balance method of depreciation, the depreciation expense in Year 3 will be closest to: A $187,200. B $259,200. C $148,000. C is correct. Under the double declining balance approach, the depreciation rate applied to the carrying amount is double the depreciation rate for the straight-l­ine method. Because the rate for the straight-­line method is 20% (1/5), the double declining rate is 40%. Depreciation expense is recorded until the net book value (NBV) reaches the residual value.

2019 Level I Mock Exam PM 33 Year 1 Year 2 Year 3 Opening NBV $1,800,000 $1,080,000 $648,000 720,000 432,000 148,000 Depreciation expense (40% of opening NBV) 1,080,000 648,000 500,000* Ending NBV A is incorrect. This is the double declining approach, but with the residual value incorrectly deducted from the depreciation base: Year 1 Year 2 Year 3 Opening carrying value 1,300,000* 780,000 468,000 520,000 312,000 187,200 Depreciation expense (40% of opening NBV) 780,000 468,000 512,000 Ending carrying value * incorrectly calculated net of the residual value B is incorrect. This is the full double declining depreciation expense that would have been recorded if the residual value had been below $388,800: Year 1 Year 2 Year 3 Opening net book value $1,800,000 $1,080,000 $648,000 (NBV) 720,000 432,000 259,200 Depreciation expense (40% of 1,080,000 648,000 388,800 opening NBV) Ending net book value Long-­Lived Assets LOS e Section 3.1 55 Under IFRS, it is most appropriate to include which of the following pension costs of a defined-b­ enefit plan in other comprehensive income? A Net interest expense accrued on the beginning net pension liability B Actuarial gains or losses C Employees service cost B is correct. Under IFRS, only actuarial gains or losses can be recognized in other com- prehensive income. A is incorrect. Net interest expense accrued on the beginning net pension liability is recognized in profit and loss. C is incorrect. Employees service cost is recognized in profit and loss. Non-­Current (Long-­Term) Liabilities LOS j Sections 4

34 2019 Level I Mock Exam PM 56 If a company repurchases its own shares and can reissue them at a later time, these shares are best described as: A preferred stock. B marketable securities. C treasury stock. C is correct. When a company repurchases its own shares and does not cancel them, they are referred to as treasury shares (or treasury stock). A is incorrect. Preferred shares (or preferred stock), a component of equity, are a type of equity interest, that ranks above common shares with respect to payment of dividends and the distribution of net assets upon liquidation. B is incorrect. Marketable securities are financial assets and include investments in debt or equity securities that are traded in a public market. Understanding Balance Sheets LOS f Section 6.1 57 Last year, a company’s current ratio was 0.96. Partial information is provided from the company’s balance sheet for the current year: Current Year ($ millions) Cash and equivalents 1,950 Intangible assets 870 Inventory 950 Goodwill 4,990 Accounts receivable 2,540 Current portion of long-­term debt 720 Total current liabilities 4,920 No other current assets or current liabilities were reported. Comparing the company’s current ratio this year with the prior year most likely indicates that the company’s ability to meet short-t­erm obligations has: A increased. B decreased. C not changed. A is correct. First identify the current assets: cash and equivalents, inventory, and accounts receivable. Then calculate the current ratio (Current assets/Current liabilities) as follows: ($ millions) Current Year Prior Year Cash and equivalents 1,950 Accounts receivable 2,540 Inventory 950

2019 Level I Mock Exam PM 35 ($ millions) Current Year Prior Year Total current assets 5,440 Total current liabilities 4,920 Current ratio 1.11 0.96 An increase in the current ratio (from 0.96 to 1.11) most likely indicates a higher level of liquidity and, therefore, an increased ability to meet short-t­erm obligations. B is incorrect. It excludes the inventory (confusing current ratio with quick ratio) and appears to have decreased: (1950 + 2,540)/4920 = 0.91. C is incorrect. It incorrectly double counts the current portion of the long-­term debt, which is already included in total current liabilities, so it appears to be unchanged: (5,440/ (4,920 + 720) = 0.964. Understanding Balance Sheets LOS d, h Sections 3 and 7 Financial Analysis Techniques LOS b Section 4.3.2 58 The following information (in millions) on a company is available: Cost of goods sold $500 Increase in total assets $250 Increase in total liabilities $200 Change in inventory –$30 Change in accounts payable –$25 The amount of cash (in millions) that the company paid to its suppliers is closest to: A $505. B $495. C $445. B is correct. Cost of goods sold $500 Minus decrease in inventory –$30 Purchases from suppliers $470 Plus decrease in accounts payable $25 Cash paid to suppliers $495 A is incorrect. Decrease in inventory treated as an increase and decrease in AP treated as decrease in cash flow: 500 + 30 – 25 = 505.

36 2019 Level I Mock Exam PM C is incorrect. Decrease in accounts payable treated as a reduction rather than an increase in cash flow: 500 – 30 – 25 = 445. Understanding Cash Flow Statements LOS f Section 3.2.1.2 59 Compared with its net income, a mature company’s operating cash flow is most likely: A the same. B lower. C higher. C is correct. For a mature company, because net income includes non-­cash expenses (depreciation and amortization), operating cash flow typically exceeds net income. A is incorrect. For a mature company, net income includes non-­cash expenses (depre- ciation and amortization), so it is expected and desirable for operating cash flow to exceed net income, not for them to be equal. B is incorrect. For a mature company, net income includes non-c­ ash expenses (depre- ciation and amortization), so it is expected and desirable for operating cash flow exceeds net income. If operating cash flows were lower than net income, this would be an indi- cation of poor earnings quality. Understanding Cash Flow Statements LOS h Section 4.1 60 A retailer provides credit cards only to its most valued customers who pass a rigorous credit check. A credit card customer ordered an item from the retailer in May. The item was shipped and delivered in July. The item appeared on the customer’s July credit card statement and was paid in full by the due date in August. The most appropriate month in which the retailer should recognize the revenue is: A May. B July. C August. B is correct. The appropriate time to recognize revenue would be in the month of July because the risks and rewards have been transferred to the buyer (shipped and delivered), the revenue can be reliably measured, and it is probable that the economic benefits will flow to the seller (the rigorous credit check was completed). Neither the actual payment date nor the credit card statement date is relevant here. A is incorrect. The order date is not relevant here because all of the critical elements in the revenue recognition process are not satisfied until July.

2019 Level I Mock Exam PM 37 C is incorrect. The payment date is not relevant here because all of the critical elements in the revenue recognition process are not satisfied until July. Understanding Income Statements LOS b Section 3.1 61 The following relates to a company’s common equity over the course of the year: Outstanding shares, at start of the year 2,000,000 Stock options outstanding, at start and end of the year (Exercise price: 100,000 $5) Shares issued on 1 April 300,000 Shares repurchased (treasury shares) on 1 July 100,000 Average market price of common shares for the year $20/share If the company’s net income for the year is $5,000,000, its diluted EPS is closest to: A $2.17. B $2.22. C $2.20. B is correct. First, determine the incremental shares issued from stock option exercise (treasury stock method): Shares issued at exercise price 100,000 share × $5 = 100,000 shares $500,000 –25,000 shares 75,000 shares Minus shares purchased with cash received at average market price: $500,000/$20 Incremental shares issues Weighted Average Shares Outstanding Original shares 2,000,000 2,000,000 shares × (12 75,000 months/12 months) Incremental shares issued, assum- 225,000 ing options were exercised 75,000 shares × (12 months/12 Shares issued 1 April months) 300,000 shares × (9 months/12 months) (continued)

38 2019 Level I Mock Exam PM (Continued) –50,000 100,000 shares × (6 months/12 2,250,000 months) Shares repurchased 1 July Weighted average shares outstanding Diluted EPS = Net income − Preferred dividends Weighted average number of shares = $5,000,000 − $0 2,250,000 shares  = $2.22/share A is incorrect. It includes the options at full value not using the Treasury stock method and forgets to prorate the others issued and repurchased $5,000,000/(2,000,000 +100,000 + 300,000 – 100,000) = 2.17 C is incorrect. It does not prorate the new shares issued or repurchased for the length of time outstanding: (2,000 + 75 + 300 – 100) = 2,275; 5,000/2,275 = 2.20. Or it ignores the buyback: (2,000 + 100 + 225 – 50) = 2,275; 5,000/2,275 = 2.198 = 2.20. Understanding Income Statements LOS h, i Sections 6.2, 6.3.3 62 When a new project reduces the cash flows of an existing project of the same firm, it is best described as a(n): A sunk cost. B opportunity cost. C externality. C is correct. A new project reducing the cash flows of an existing project is an externality called cannibalization. A is incorrect because it is an example of cannibalization and not a sunk cost. B is incorrect because it is an example of cannibalization and not an opportunity cost. Capital Budgeting LOS b Section 3 63 A company has 100 million shares outstanding. The share price of a company’s stock is £15 just prior to announcing a £100 million expansionary investment in a new plant, and the company estimates that the present value of future after-­ tax cash flows will be £150 million. Analysts, however, estimate that the new plant’s profitability will be lower than the company’s expectations. The compa- ny’s stock price will most likely: A drop below £15 per share due to the cannibalization of revenue from the new plant.

2019 Level I Mock Exam PM 39 B increase by less than £0.50 per share. C increase by the new plant’s net present value per share. B is correct. The value of a company is the value of its existing investments plus the net present values of all of its future investments. The NPV of this new plant is £150 million – £100 million = £50 million. The price per share should increase by NPV per share or £50 million/100 million shares = £0.50 per share. As the new plant’s profitability is less than expectations, the NPV per share (and hence the increase in the stock price) should therefore be slightly below £0.50 per share. A is incorrect. It is only new plant’s profitability that is below the average not the overall. The company value should not fall below £15 per share, all things being equal. C is incorrect. See the above calculation. Capital Budgeting LOS f Section 4.10 64 Which of the following conditions is most likely to facilitate shareholder activism? A Cross-­shareholdings B Cumulative voting C Staggered boards B is correct. Cumulative voting facilitates shareholder activism by allowing shareholders to accumulate and vote all their shares for a single candidate in an election involving more than one candidate. Minority shareholders, who may be activist shareholders, are more likely to successfully elect a board member in this way. A is incorrect. Cross-­shareholdings inhibit shareholder activism because the manage- ment teams of the cross-­held companies implicitly agree to use their votes to support each other’s interests. C is incorrect. Staggered boards inhibit shareholder activism by limiting the number of board members that are elected in a given year. This makes it difficult to implement immediate change. Corporate Governance and ESG: An Introduction LOS d, b Section 4.2.1 65 The least likely reason investors incorporate environmental and societal factors into their investment analysis is to: A improve investment performance. B have a more comprehensive understanding of a company’s risks. C limit investments to those equities that are consistent with their moral or ethical values.

40 2019 Level I Mock Exam PM C is correct. Environmental, social, and governance investment analysis can be imple- mented across all asset classes and is not limited to equity investments. It is done to provide a more comprehensive understanding of a company’s risks and improve investment performance. A is incorrect. ESG is done to provide a more comprehensive understanding of a company’s risks. B is incorrect. ESG is done to improve investment performance. Corporate Governance and ESG: An Introduction LOS j Section 9 66 A company’s data are provided in the following table: Cost of debt 10% Cost of equity 16% Debt-­to-­equity ratio (D/E) 50% Tax rate 30% The weighted average cost of capital (WACC) is closest to: A 14.0%. B 11.5%. C 13.0%. C is correct. Convert the D/E to determine the weights of debt and equity as follows: wd = DE = 50% = 33.3% 1+ D E 1 + 50% we = 1 – wd = 66.7% WACC = wdrd(1 – t) + wprp + were = 33.3% × 10% × (1 – 30%) + 66.7% × 16% = 13.0% A is incorrect because the debt is not tax adjusted when determining the WACC. WACC = 33.3% × 10% + 66.7% × 16% = 14.0% B is incorrect because the D/E is used as the weight for debt and equity. WACC = 50% × 10% × (1 – 30%) + 50% × 16% = 11.5% Cost of Capital LOS a, b Sections 2, 2.1, 2.2 67 When estimating the NPV for a project with a risk level higher than the com- pany’s average risk level, an analyst will most likely discount the project’s cash flows by a rate that is: A determined by the firm’s target capital structure. B below the WACC.

2019 Level I Mock Exam PM 41 C above the WACC. C is correct. If the systematic risk of the project is above average relative to the com- pany’s current portfolio of projects, an upward adjustment is made to the company’s MCC or WACC. A is incorrect. The firm’s target capital structure is used to determine WACC, but in this case we need more adjustment in the company’s WACC. B is incorrect. If the systematic risk of the project is above average relative to the company’s current portfolio of projects, an upward adjustment is made to the compa- ny’s MCC or WACC. Cost of Capital LOS e Section 2.3 68 A class of noncallable, nonconvertible preferred stock was issued at $45.00 per share with a dividend of $5.25. The preferred stock is now trading at $60.00 per share. Earnings of the company are growing at 3.00%. The cost of preferred stock is closest to: A 11.7%. B 8.8%. C 5.8%. B is correct. The cost of preferred stock is: rp = Dp Pp where: rp =the cost of preferred stock Dp =the preferred stock dividend per share Pp =the current preferred stock price per share The cost of preferred stock is 5.25/60.00 = 8.75% C is incorrect. If the dividend growth rate of 3% is subtracted from 8.75% (as per the Gordon growth model), the conclusion will be 5.75%. A is incorrect. If the issuance cost is being used instead of current price, it will lead to a wrong conclusion of 11.67%. Cost of Capital LOS g Section 3 69 Which of the following statements is the most appropriate treatment of flota- tion costs for capital budgeting purposes? Flotation costs should be: A expensed in the current period. B incorporated into the estimated cost of capital. C deducted as one of the project’s initial-p­ eriod cash flows.

42 2019 Level I Mock Exam PM C is correct. Flotation costs are an additional cost of the project and should be incor- porated as an adjustment to the initial-­period cash flows in the valuation computation. A is incorrect. Expensing is an accounting treatment of the costs, not a capital bud- geting treatment. B is incorrect. Including the flotation cost in the estimated cost of capital is theoret- ically incorrect. By doing so we are adjusting the present value of the future cash flows by a fixed percentage, i.e., the adjusted cost of capital. Cost of Capital LOS l Section 4.4 70 Business risk most likely incorporates operating risk and: A financial risk. B sales risk. C interest rate risk. B is correct. Business risk is the combination of sales risk and operating risk. A is incorrect because does not include financial risk. C is incorrect because business risk does not include interest rate risk. Measures of Leverage LOS a Sections 3.1, 3.2 71 The following data apply to two companies producing similar products. Company A Company B Number of units produced and sold 1 million 1 million Sale price per unit $100 $100 Variable cost per unit $60 $50 Fixed operating costs Fixed financing expenses $20 million $40 million Degree of operating leverage (DOL) $10 million $5 million Degree of financial leverage (DFL) ? 5.0 2.0 2.0 Compared with Company B, Company A has: A a higher degree of total leverage. B a lower sensitivity of operating income to changes in units sold. C the same sensitivity of operating income to changes in net income. B is correct.

2019 Level I Mock Exam PM 43 Company A Company B 5.0 (as given) Degree of operating leverage (DOL) 1 million × ($100 − $60) million × ($100 − $60) − 2.0 (as given) DOL = Q(P − V) 1 $20 million = 2.0 Q(P − V) − F 5.0 × 2.0 = 10.0 Degree of financial leverage (DFL) 2.0 (as given) DFL = Q(P − V) − F C Q(P − V) − F − Degree of total leverage (DTL) 2.0 × 2.0 = 4.0 DTL = DOL × DFL The DOL is lower for Company A than Company B (as per the table), meaning Company A’s operating income is less sensitive to a change in the units sold relative to Company B. A is incorrect. DTL for Company A is lower than for Company B (as per table above). C is incorrect. DFL for both companies equal to 2.0. However, the interpretation of DFL should be the sensitivity of net income to changes in operating income. Measures of Leverage LOS b Sections 3.3–3.5 72 The unit contribution margin for a product is $12. Assuming fixed costs of $12,000, interest costs of $3,000, and a tax rate of 40%, the operating breakeven point (in units) is closest to: A 1,250. B 750. C 1,000. C is correct. The operating breakeven point, QOBE, is: Fixed operatin=g costs $=12,000 1,000 Contribution margin $12 B is incorrect because the numerator is ($12,000 + $3,000) × (1 – 40%). A is incorrect because the numerator is ($12,000 + $3,000) making it the breakeven quantity, QBE, and not the operating breakeven quantity, QOBE. Measures of Leverage LOS e Section 3.6 73 The following information is available for a company’s bank account: Total deposits (millions) $16.0 Average daily float (millions) $2.5 Number of days 15 The float factor for the company is closest to: A 2.3. B 6.4.